Saturday, September 15, 2007

How Should The Money Supply Be Defined?

Mike Shedlock argues against the view that there is strong inflationary pressures in the U.S. economy. Since I am one of those who have argued for that view, I feel I must reply. Ultimately, the disagreement is a disagreement of how the money supply should be defined. The broader definitions that I favor show a lot faster growth than the narrower definition that he favor.

Mike Shedlock is generally a good economic analyst, but he suffers from one fatal flaw: he believes in Frank Shostak's definition of the money supply. The problem with that is that Shostak have a far too narrow definition. Exactly which items are included in that definition is not clear, as he in his article about the money supply only argues against including certain items, rather than specifying exactly what is included. But it seems fairly similar to M1.

Shostak for example excludes Money Market Mutual Funds despite the fact that you can use your holdings in them as a means of payment by for example writing a check on the ground that when you write a check you instruct the fund to sell assets and then the money is transferred to the holder of the check and so money is only transferred, not created. But this is just another case of Shostak being completely clueless. Advocates of including MMMF:s in the money supply have never argued that money is created when people reduce their MMMF holdings by for example writing a check. Quite to the contrary, here the money supply is being reduced as MMMF holdings fall while the amount of cash is held constant and transferred from the buyer to the seller. The money creation instead occurs when people deposit money in MMMF as the seller of the assets receives cash while the depositor simultaneously also has money in the form of MMMF assets, while before the transaction only the future depositor had money in the form of cash.

Shostak also argues against including saving deposits because banks formally have the right to insist on a 30 day waiting period. But to this Murray Rothbard pointed out:

"The objection fails to focus on the subjective estimates of the situation on part of the depositors. In reality, the power to enforce a thirty day notice on saving depositors is never enforced; hence, the depositor invariably thinks of the savings account as redeemable in cash on demand. Indeed, when in the 1929 depression, banks tried to enforce this forgotten provision in their savings deposits, bank runs promptly ensued"

Thus, since money deposited in savings deposits can be used as a means of payments they should be included in the money supply. That should be the general principle in determining what is and what isn't money: can it be used as a means of payment. That would indeed include both savings deposits and MMMF:s.

Shedlock also tries to put up an empirical defense of Shostak’s definition. He claims that it accurately predicted 6 out the latest 6 recessions, although he concedes it gave two false signals, in 1985 and 1995. However, looking at his chart, it did not in fact predict the most severe of all recessions, the one in 1981-82, where it fluctuated between 5 and slightly above 10% during and before the recession, but did not show a downward trend.

What's worse, the measure failed to predict the late 1990s tech stock bubble, as money supply growth remained moderate during the entire era. By contrast, measures like M3 and MZM did rise in reflection of the tech stock bubble.

Also, recessions need not be associated with falling money supply growth if there is stagflation. Money supply growth has been extremely high and rising in Zimbabwe recently, yet Zimbabwe has suffered a sharp drop in economic activity. It all depends on who the early receivers of money are and how they use it. Sometimes it can cause tech stock bubbles, sometimes it can cause housing bubbles and sometimes it can simply cause consumer price inflation. Theoretically it can also have no effect at all on any prices if the early receivers decide not to use it. The latest acceleration in monetary growth is most likely to cause an acceleration in consumer price inflation, which I expect to rise above 4% later this year.

7 Comments:

Anonymous said...

How do we know the numbers the central bank reports on money supply growth are accurate? In the U.S., the CPI is widely known as a fraudulent figure. There are also criticisms of GDP, unemployment etc because of methodology. And if U.S. dollar supply is flat and U.S. dollar demand is falling, say by 5% annually for the sake of argument, doesn't that mean they are still inflating the money supply relative to demand ?

If by margin lending you are referring to a broker giving you the ability to purchase stocks beyond the money you paid into your brokerage account and the stocks are purchased on the open market, the answer would have to be no. The transaction of margin lending per se does not increase the money supply. What happens is that your brokerage account is credited with the stocks you purchased and the sellers brokerage account is credited brokerage account funds. If he decides to transfer this money to his checking account or cash out, then the money supply would increase.

The only possibility for the money supply to increase immediately from margin lending would be if you purchase stocks from an initial public offering directly from the issuer on margin. Then money would be credited to the issuing corporation's checking account. But this is rather unlikely because the stocks are usually underwritten and sold by banks as intermediary organizations which would already affect the money supply before you do anything.

More details on how to define the money supply is at http://nimamahdjour.blogspot.com/2008/03/money-supply-watch.html

"Advocates of including MMMF:s in the money supply have never argued that money is created when people reduce their MMMF holdings by for example writing a check. Quite to the contrary, here the money supply is being reduced as MMMF holdings fall while the amount of cash is held constant and transferred from the buyer to the seller"

It is correct to "money supply is being reduced as MMMF holdings fall" by your definition. The buyer is increasing his MMMF holdings surely?

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